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When projecting our target range for the S&P 500 for May 2010, we indicated that we believed the sharp deceleration we observed in the growth rate of stock prices in April were driven by a combination of fundamental aspects (investors expecting a negative change in the expected future growth rate of dividends) and noise (the continuous, short-term shaping of investor expectations in reaction to countless sources of new, often randomly-timed information.)

Yesterday, we explored the potential effects of what is, at present, a contributor to the noise influencing stock prices today: the expectations that investors have for falling stock market dividends into 2011 in reaction to higher taxes being levied against them.

Today, we'll consider a more fundamental driver of investor expectations that would indicate lower stock prices: an expected drop in the stock market's dividends per share in 2011 resulting from a declining business situation in the U.S. economy.

The modern godfather of business cycle tracking, Bob Bronson, has a bearish view for how the U.S. economic situation is developing. Barry Ritholtz) describes Bronson's views:

Bob’s beef is that the headline figure of 3.2% annualized growth was down 40+% from the Q4 growth rate of 5.6%. Hence, we see a sharp deceleration in the so-called economic recovery. Hardly what one would expect to see in a healthy robust post recession expansion.

And though Q1 was the third consecutive quarter of positive growth following three quarters of negative growth, this does not automatically mean we will have a balanced, V-shaped recovery, nor does it preclude a double dip recession.

Rather than focus on GDP, investors should pay attention to what Bob terms "the core business cycle" — below:

The second chart below illustrates the Q1 GDP update of our working model of the double double-dips we expect, followed by a range of possible similar shapes of what can be more broadly thought of as a very wide U-shaped trough, or \____/ , rather than even the upside-down square root sign that only a few economists are expecting, as compared to the deep and/or sharp V-shaped and eventually self-sustaining recovery that the current consensus of them expects.

What we're going to show you next will seem to come from left field, but shows surprising agreement with the results Bronson obtained by considering the interaction of multiple cycles that he sees occurring simultaneously in the U.S. economy. The chart below presents Ivan Kitov's predicted vs observed monthly closing value for the S&P 500 from 2008 through the end of 2011 (note: the red line isn't a linear regression trend line fit to the observed data - instead, it's Kitov's forecast for what the trend would be for the S&P 500 price level made in March 2009):

Why that might seem to come from left field despite closely tracking what Bronson anticipates is that Kitov's forecast is based upon the number of nine-year olds in the United States!

That might sound crazy, but Kitov doesn't actually believe nine-year-olds are controlling the stock market. Instead, he's found that the number of nine-year olds works as a really good proxy for the economic activity of their parents, which directly affects the U.S. economy more than any other age-demographic group.

In demographic terms, the parents of nine-year old children are the people in the United States who are most likely to be in their peak consumption years, who are engaging in major financial transactions such as buying the largest house they'll own in their lifetimes, as well as things that fill it and the vehicles they need to haul their families around, et cetera.

It's the combination of the things that the parents of nine-year-olds buy with their numbers that makes them so economically influential. That combination would be why the fundamental business situation in the U.S., the sustainable portion of whose profits drives the stock markets, can be reasonably predicted from knowing how the number of nine-year-olds in the U.S. is changing.

And the number of nine-year-olds in the U.S. will be declining in the short term, so guess what effect that will have on the U.S. economy, and by extension, the U.S. stock market....

The question for us though is how much of stock prices today are the result of noise versus more fundamentally driven economic factors. For our methods of anticipating where the stock market will go, we won't have a good sense of that until we can see the the market's dividend futures are available beyond December 2010 or March 2011.

Given what we see today however, we can reasonably expect stock prices to be going lower.

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